LIBOR: A Short Guide on the London Inter-Bank Lending Rate

LIBOR, or the London Inter-Bank Lending Rate when not abbreviated, is one of the most fundamental interest rates in the financial world. It can be a confusing thing for bankers, let alone those of us who are not in the business. So, what’s it all about and how does it affect you?

In a nutshell, LIBOR is the rate at which banks borrow from other banks. It was created back in the 80s, designed to create reliable interest rates for banking derivatives. Today, this it is a worldwide benchmark, so ignore what ‘London’ may suggest. Indeed, banks and their systems all over the world abide by the London Inter-Bank Exchange Rate. As of 2012, LIBOR is used to set an overall interest rate on various financial deals, worth approximately 450 trillion (dollars). This is essentially what the system is used for, but there is a lot more to it than just that. Of course, banking terminology is not something that we can all immediately speak. It takes time to become fluent in banking lingo, and thus we are here to try and process the language of bankers into your own language.

LIBOR: A Short Guide on the London Inter-Bank Lending Rate

Why Does This Banking Lending Rate Matter?

LIBOR ultimately determines the price of worldwide transactions. On top of this, the London Inter-Bank Lending Rate is also often used to determine how well a bank is doing financially. On the contrary, there are interest rates attached to each borrowing. These rates are often determined by the leading banks. This rate is effectively used as a measure of trust in most cases. All of the world’s leading banks do not lend each other money as an act of charity. These rates are offered in 10 different currencies, including the pound, US dollar, Yen and the Euro. There is also a total of 15 lengths of a loan to choose from, ranging between overnight to a full year.

Thus, lending money from the world’s leading banks comes at a price. The three-month dollar LIBOR is the most important of all rates. In this case, the rates submitted are what the banks approximate they would pay to other banks to lend dollars for three months if they loaned money on the day the rate is set.

What Exactly Is It Used For?

Adjustable-rate loans are often determined by the London Inter-Bank Lending Rate. So too are credit card debt and interest-only mortgages. LIBOR is also the rate employed to determine the price for interest rate swaps and credit default swaps. These ‘swaps’ are a type of insurance protection in the case of default of loans. In a twist of fate often associated with bankers, these swaps ultimately brought about the financial downfall in 2008. This was because many banks were lead to believe that these swaps would have no negative effect on mortgage-backed securities. However, lurking behind these derivatives were the subprime mortgages, which were void and began to default. Thus, many insurance companies hadn’t the money to cover the cost of all these swaps. AIG suffered terribly due to this mirage and ultimately crumbled.

(Just a quick note: if all this seems a bit hazy but you would like to know everything about it, try watching The Big Short, starring Ryan Gosling, Brad Pitt, Steve Carrell and Christian Bale. This film deals with the financial crisis of 2007/8. The movie goes into great detail when explaining banking terms such as ‘subprime mortgages’ and ‘collateralized debt obligations’. It’s also very entertaining).

Have There Been Problems With LIBOR?

Indeed there have been. It’s important to bear in mind that all the LIBOR rates set were at one point estimates, and were therefore open to interpretation, or manipulation. Thus, many bankers across the world have in the time taken advantage of these estimates. Submitting false figures is a tactic which many conspiring bankers employ. The estimated rates were sometimes lower or higher than the actual rate. All of this was in favor of financial gain. It’s no surprise that many bankers will discuss and decide to provide false figures in order to earn some quick cash and lots of it in that regard.

Over the past few years, some of the world’s leading banks have been proven guilty of indulging in this profitable practice. To name a few of those within the guilty party: Barclays, Swiss Bank, JP Morgan, The Royal Bank of Scotland, and Deutsche Bank have all been caught out and brought to justice over their manipulation of the LIBOR rate. And what are the penalties for those caught? In one such case, banker Tom Hayes, a former employee of UBS and Citigroup, is currently serving an 11-year jail sentence for the manipulation of the LIBOR rate. When breaking the law in banking, the consequences are rarely light.

How Does This Lending Rate Ultimately Effect Us?

Are there still risks of manipulations and therefore banking crashes? Not as much as there used to be. Governments worldwide have taken the instability that estimation creates, and have therefore devised a system which provides actual rates rather than estimations. LIBOR was once in the hands of the BBA (British Banker’s Association) but has since been passed over to the ICE (Intercontinental Exchange) following the aftermath of such banking crises aforementioned.

Other lawful impediments include the charges for such manipulation of LIBOR. As seen in the above case for Tom Hayes, there are now set offenses and charges for the manipulation of the London Inter-Bank Lending Rate. Thus, with no more estimations and fierce prison sentences looming over those who dare to risk it all for a profit, banking crashes related to LIBOR are now less likely than they were ten years ago.

For those of you who have an adjustable rate loan, it’s important to know that as LIBOR rises, so does the costs for your payments. The same goes for any outstanding credit card debt.

Conclusion

Banking terminology will forever remain a labyrinth of smoke screens for those of us outside the section. With some basic knowledge as given above, it’s possible to remain in the know how. So just be aware of how much LIBOR affects the financial world. It may indeed be the reason for the next crash. If anything like this should occur, terms such as ‘LIBOR’ won’t be so baffling anymore.